Dividend Payer American Capital Agency Corp. Made Hay In The New Dollar Roll Market

American Capital Agency Corp. (NASDAQ:AGNC) is a mortgage REIT that invests in Agency securities (RMBS). Its goal is to preserve net asset value, while generating attractive risk-adjusted returns for distribution to its stockholders via regular quarterly dividends. It does this through a combination of net interest income and net realized gains and losses on its investments and hedging activities. It funds itself primarily through repurchase agreements (with a base of capital from shareholders). AGNC is externally managed and advised by American Capital AGNC Management LLC, which is a wholly owned subsidiary of American Capital Ltd or American Capital (NASDAQ:ACAS) - a publicly traded private equity firm and global asset manager.

A consequence of QE3 (the Fed buying of $40B/month in MBS) and the Fed's re-investing strategy of about $30B/month in MBS is that it created the Dollar Roll market. A mortgage "dollar roll" is a transaction in which the investor sells an MBS for delivery in one month at a specified price. The investor simultaneously buys the same security for delivery in a future month at a lower price. The difference between the two prices is called the drop (usually quoted in 32s). The drop is the result of the 30-day commercial paper rate, the expected principal, the interest payment on the mortgage, and the demand/supply of the mortgage in the market place. Using this transaction a portfolio manager can either receive cash for the bonds for one month, or the portfolio manager can delay the cash payment for the security by a month (put off buying a security, but contract for it). The net effect is that the investor is able to maintain mortgage exposure while having the cash to reinvest. The buyer is typically a broker/dealer trying to cover a short position in the specified coupon mortgage.

Apparently the large amount of buying by the Fed (QE3) has led to a number of dealer shorts. They "pre-sell" (short) mortgages they expect to be available to buy, but these mortgages do not become immediately available due to demand issues. By buying the "roll," the dealers buy themselves the time to buy mortgages to cover their original sales. When selling, the "roll" is a positive arbitrage for the investor. He will roll his bonds. Apparently AGNC excelled at identifying and capitalizing on positive arbitrage situations in Q4 2012. There is no guarantee that this will always be true. Of course, there is also the thought that AGNC just used this method to buy RMBS more cheaply. If you decide you cannot time perfectly, it makes sense to grab a profit on the entry if you can. The TBA (to be announced) MBS market is a one to three month forward market.

The bottom line in all of this is that AGNC effectively raised its leverage to 8.2x at Q4 end (7.0x without the TBAs) due to its approximately $13B in forward TBAs. By doing this it was able to capture an estimated incremental $0.29 per share during Q4 2012. The company added that to its net income spread income of $0.89 per share get to $1.18 per share (or $1.07 excluding a $0.11 in catch-up component). Effectively it also increased the value of its investment portfolio to $98B including TBA mortgage positions (as of December 31, 2012) versus $85B without the TBA mortgage positions. As of December 31, 2012, AGNC had a net interest rate spread of 1.61% including TBA mortgage positions or 1.39% excluding TBA mortgage positions. Overall this seems an improvement over the average net interest rate spread of 1.42% for Q3 2012. However, the TBA mortgage moves also mean more risk.

So far the company's management has navigated the TBA mortgage area successfully. That may not always be the case, and the negative effect of failure could be large. However, in Q4 2012 AGNC's TBA activity helped to counter the $0.85 per common share in book value loss (from $32.49 at Q3 end to $31.64 at Q4 end). The company was able to raise its undistributed taxable income per common share to $2.18 (or +$0.66 per common share) during Q4. This makes AGNC's dividend of $1.25 look much more stable for now. In AGNC's case it is mostly using the dollar roll market to forward purchase Agency MBSs. This gives AGNC very favorable financing costs. Given that AGNC's purchase timing may not be perfect in any case, this seems like an acceptable strategy. However, it is a strategy that is only likely to work while the Fed is buying huge amounts of MBS (about $70B per month). Many think this will continue to be the case throughout 2013. However, it could change at almost any time. The table below gives an example of what AGNC has been doing with the dollar roll.

The average CPR for AGNC's portfolio was only moderately changed in Q4. It went up to 11% from 9% in Q3 2012 (normal fluctuation for AGNC). Mortgage rates climbed, and they have continued to climb in Q1 2013. This likely means more book losses. However, it should also mean a higher net interest rate spread in Q1 2013. This should mean greater profits. The chart of the 30 year US Treasury bond yield gives a good idea of how mortgage rates have been trending (some are tied to the long bond).

As you can see, the upward trend has continued in 2013. The 30 year fixed rate mortgage is at 3.61% this week. This is significantly above the fall low of about 3.30%. Apparently "printing money" (QE4 especially) has had some inflationary effects. As long as this trend does not continue too long, it bodes well for AGNC, which should see its net interest rate spread widen as a result.

To be clear, FMV is fair market value. WALA is weighted average loan age. CPR is constant prepayment rate. HARP is defined as pools backed by 100% refinance loans with original loan to value ratios >= 80%. The weighted average original LTV (loan to value) is approximately 95% for 15 year loans and 104% for 30 year loans as of December 31, 2012.

AGNC's great CPR performance has been largely because its Agency RMBS are comprised of 77% HARP (as defined above) or lower loan balance securities as of December 31, 2012. The chart below shows just how much this loan type selection (lower loan balance and higher LTV HARP loans) has outperformed the general market (in terms of CPR%).

(click to enlarge)

The table below shows AGNC's economic performance over FY2012.

(click to enlarge)

You can see that the net interest rate spread has deteriorated over 2012. However, the recent rise in mortgage rates, which has been confirmed by the recent rise in the 30 year US Treasury Bond yield, indicates that the net interest rate spread may will expand in Q1 2013. There is no overriding reason for CPRs to spike short term, which is the only thing that would likely prevent such an occurrence. It is hard to tell exactly where net interest rate spread will go from there.

Part of the net interest rate spread performance will no doubt be dependent on how the US economy does in the near term. It seems headed for a slowdown, if not a recession. If the slowdown/recession is mild, AGNC should still perform well. If it is not, you may wish to temporarily sell your AGNC to avoid a significant move downward.

Most Agency RMBS sell at a premium to face value. In a recession a significant part of these could get foreclosed on. The government would presumably make the loans good. However, the prepayment rate would go up dramatically. AGNC would lose the monies in excess of the face values it paid for these Agency RMBS. AGNC might be able to recover some of this through hedges, but overall such an event would be negative for AGNC, especially with respect to its book value. Let's hope for a mild recession at worst. As of the end of Q4 2012 AGNC's amortized RMBS cost basis was 105.6%. That is worrisome in a possibly very troubled environment.

Overall AGNC seems to be navigating troubled waters well. It is a buy, but it is a buy with a caveat. In case of a recession, you want to sell. The cost basis of its Agency loans is too high to do well in a recession. Still it is a well managed company, and I would want to buy back in at the bottom of the recession, if one occurs.

Whether or not a recession occurs in the US in 2013 may be significantly determined by how Congress and Obama deal with the sequestration issue scheduled currently for March 2013.

The two year chart of AGNC provides some technical direction for this trade.

(click to enlarge)

Since AGNC was a May 2008 IPO, there is little point in looking at its longer term performance with regard to a recession. The slow stochastic sub chart shows that AGNC is neither overbought nor oversold. The main chart shows that AGNC is in a weak downtrend. It does seem to have bounced off its lows. However, it is now above its book value of $31.64 at a price of $32.30. Therefore it would be best to wait for a pullback before buying it. There are significant worries with this stock, even though it has been a great performer over FY2012 with a 32% economic return on common equity for the full year.

If you see a recession coming, you will probably want to exit this stock. The premium cost it paid for its Agency RMBS is too high to do well in a recession. Management might manage to save the situation, but they would be rowing against the current. Still the management team is a good one. They deserve your loyalty until such a recession does rear its ugly head.

The Q4 GDP growth first reading was an ugly -0.1%. However, the US trade deficit for December 2012 of -$38.5B was much lower than the expected -$45.4B deficit. Most think this will push the Q4 GDP revisions into positive territory. Therefore an official recession is still a long ways off. A bad number for Q1 2012 GDP growth of under -1.0% would likely make me seriously consider selling. I might also sell on a disastrous sequestration negotiation between Congress and President Obama. AGNC has an average analysts' recommendation of 2.2 (a buy). AGNC does pay a great 15.56% dividend (as of the close on Friday February 8, 2012), which seems safe for now. Plus its management team may continue to be able to benefit from the dollar roll throughout 2013. If so, this would give AGNC a significant lift.

NOTE: Some of the fundamental financial data above is from Yahoo Finance.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AGNC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
PRO Alerts is our flagship product for individual investors who want to be faster
and smarter about their stocks. To learn more about it, click here.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!